On May 15th, 2014, Standard & Poor’s Rating Services issued Climate Change is a Global Mega-Trend for Sovereign Risk, a report about the potential impacts of climate change on sovereign credit ratings of countries around the world. In its report, S&P explains how the costs of inaction on climate change in response to increasing frequency and destructive force of extreme weather events will become large enough to adversely influence countries’ credit ratings.

S&P labels climate change as a new mega-trend that is increasingly part of public discussion on global economic risks. The report makes it clear that our lack of understanding of climate change and the interconnected nature of ecological systems make it difficult to predict precisely if and when global warming and changing weather patterns will outweigh other economic trends or risks for most sovereign nations. It particularly specifies three factors that make climate change a challenging problem to control.

First, the inherent intricacy of science provides a wide array of possible outcomes and interpretations which leave significant uncertainties and controversies about how climate change will impact national economies and financial systems. Since the benefits from taking remedial measures lie in the distant future whereas the immediate consequences of taking action are unpopular among current electorates, the uncertainty about future climatic conditions hinders political action.

Second, the nature of global collective action leads to the famous prisoner’s dilemma. Due to the global character of climate change, most benefits from sacrificial efforts of individual societies to respond to climate change will accrue to other nations, resulting in an incentive structure that leads to uncooperative outcomes and to little effective risk mitigation.

Third, the expectation of disproportionate impact on poorer countries with less clout in international negotiations further exacerbates the international coordination problem.

Then, the report discusses how climate change can affect sovereign ratings. S&P has so far not changed any credit rating in response to the devastation caused by natural disasters. However, with increasing frequency and destruction of extreme weather events, S&P expects to incorporate this trend into its ratings methodology. Among its five key factors for ratings—institutional and governance effectiveness, economic structure and growth prospects, external liquidity and international investment position, fiscal performance and flexibility, and monetary flexibility—S&P believes that economic, fiscal, and external performance will be the main factors through which climate change could feed through to sovereign ratings.

S&P is particularly concerned about the impact of changing patterns of rainfall on economic performance. Floods, repeated and prolonged droughts, or heat waves and wildfires caused by the changing patterns not only impact agricultural yields, but also reduce productivity by deteriorating sanitary conditions and increasing morbidity of workforce through pests or diseases. In coastal areas, rising sea-levels could salinize water supplies. The evidence suggests that, other things being equal, climate change will negatively impact welfare and economic growth potential for most national economies, leading S&P to lower sovereign ratings on the most affected nations.

Major climate-related disasters place potential tolls on fiscal performance as well. Unanticipated disaster recovery and emergency support and reconstruction of economic and social infrastructure often have negative impacts on public finances. If the underlying national economy falters, government budgets can be strained by decreased tax revenues. If climate-related pressures simultaneously increase in other countries, as is likely to be the case in a climate changed world, a national economy cannot count much on external supports. These factors will potentially put downward pressure on sovereign ratings as national debts and deficits mount.

In today’s globalized world with closely intertwined economies, external performance also is a force to be reckoned with in terms of its influence on sovereign ratings. For example, when a nation that depends on exports of agricultural production for foreign currency is hit by irregular climate patterns, the response of external actors may exacerbate the nation’s financial condition. Unpredictable weather patterns can undermine the export base, raise trade imbalancesand cause the level of foreign reserves to become threatened. As a result, inflation will rise and prosperity levels will fall. Terms of trade of net food importers will deteriorate due to their weakened capacity to absorb the financial cost, putting pressure on their external accounts, which in turn will increase the risks for sovereign ratings.

Lastly, the report discusses how climate change exposes low-rated sovereigns to higher risks. It identified Vietnam, Bangladesh, and Senegal as the most vulnerable nations, and Luxembourg, Switzerland, and Austria as the least at risk. Using a composite of three different variables—the ratio of population living below five meters of altitude, ratio of agricultural production in GDP, and Notre Dame University’s vulnerability index—and devising a “crude” ranking of 116 nations according to their potential vulnerability, S&P concludes that the more vulnerable countries also tend to be poorer, causing them to bear disproportionate risk of ratings downgrades as well as physical impacts.

What are the potential policy implications of this report? Changes in sovereign credit ratings receive considerable attention in financial markets. Therefore, governments generally strive to achieve higher ratings which ease their access to international capital markets, attract investments, and increase their market liquidity. Consequently, the report’s prediction of the potential impacts on sovereign ratings caused by climate change may influence the scope and the direction of national policies regarding climate change. And since the impact of rating changes on spreads is much stronger for below-investment-grade than for investment-grade sovereigns (see “The Uses and Abuses of Sovereign Credit Ratings” for details), low-rated sovereigns (below BBB- for Fitch and S&P or Baa3 for Moody’s), such as Bangladesh and Vietnam, may feel more urgent need to change their national policies to adapt to climate change. Without sufficient measures taken by these nations, they will experience vicious cycles of low national wealth, vulnerability to climate change, increasing frequency and destruction of extreme weather events, and strong susceptibility to changes in credit ratings.

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This blog provides a forum for legal and policy analysis on a variety of climate-related issues. The opinions expressed here are solely those of the individual authors, and do not necessarily represent the views of the Center for Climate Change Law.